In: Finance
An acquisition premium is the difference between the actual price paid to acquire a company and the estimated real value of the acquired company before the acquisition. It is often recorded as "goodwill" on the balance sheet.
Let's assume Company XYZ wants to acquire Company ABC. If Company ABC is worth $15 per share but Company XYZ offers $20 per share, this means Company XYZ is willing to pay a 30% acquisition premium ($20 - $15)/$15.
Although acquisition premiums can run quite high, not every company pays an acquisition premium for a target. Furthermore, not every company intentionally pays an acquisition premium.
For instance, if Company XYZ offered $20 per share when ABC was trading at $20, but then ABC shares fell to $10 per share before the acquisition was complete, Company XYZ would find itself paying a 50% premium. In most cases, however, this dramatic drop in share price would probably cause Company XYZ to withdraw its offer.
The size of the premium often depends on various factors such as competition within the industry, the presence of other bidders, and the motivations of the buyer and seller.
Most companies pay acquisition premiums for two reasons: (1) to ensure that the deal gets closed and (2) because they feel that the synergies generated by the combined entities will be greater than the total price paid for the target.
The decision of how much to pay for an acquisition target involves professional judgment beyond that which comes from evaluating spreadsheets. After all, even if paying an acquisition premium benefits the target's shareholders, paying a higher acquisition premium puts more pressure on the acquiring company to produce the results its inherited shareholders will expect.
Acquisition premiums are generally measured by taking the difference between the stock price
paid to a target firm, and the price of the target's stock at some point in time before the deal, divided by the target's Mock price before the deal. Paying a premium indicates that the value of the large company is higher to the acquirer than it is to its original owner(Diaz & Azofra, 2009). This higher value can come from factors such as economies of scale and scope, diversification leading to risk reduction and a higher market power of the combined institutions. These premiums can be significant, Betton et al. (2008) for example report that between 1980 and 2002 the average premium paid for an American target is 48% of the market value of the target before the bid.
Cal-fen (2011) argues there are four main theoretical explanations why premiums are paid in M&A. The author mostly uses these five explanations to explain overpayment, however to get good understanding of the l'undamental idea of why a premium is paid they will be described way of sharing the synergy created by merging the two entities. Synergy means that the two firms
merged would profit from factors such as economies of scale and scope, where the combined effect is larger than the sum of the separate effects. In constructing an M&A deal, a synergy value is determined and the acquirer shares some of this synergy value with the larget in the form of shortly.
Firstly, Cai-len mentions the synergy theory. Monden (2010) describes the premium as premium puid in the larget stock price. This sharing occurs because there is double information asymmetry (Hansen, 1987).
Secondly, the signal theory as described by Baron (1983) offers a more tactically oriented explanation for paying higher premiums. Parties making a bid might use the high amount to discourage other bidders from getting involved. Furthermore, a high bid might induce a quick closing of the deal saving the acquirer both time and money.
Third, agency theory as described by Jensen and Meckling (1976) describes how management of an acquiring company indulges in opportunistic behavior. This might lead to 'empire building' in which managers attempt to maximize their reputation as leaders of giant conglomerates (Hope & Thomas, 2008). This explains why they would pay a premium to overtake another firm, to serve their self-interest.
Finally, behavioral theory explains how premiums might be driven upward because managers suffer from hubris (Malmendier & Tate, 2005). Managers from the acquiring firm might be overoptimistic concerning the profits from the joint operation. By looking at the determinants of premiums, this thesis will investigate premiums from
the perspective of synergy theory. Whereas all four theories mentioned before help to understand why premiums are paid, the synergy theory is best suited to better understand which ex ante factors are taken into account when determining a premium in actual deals. The other theories help explain ex post why a premium paid might have been incorrect based on results of the merged
company. When an offer price is determined, it is unlikely that acquiring management factors in its own overconfidence or opportunistic incentives. They will however, model future profits and base the premium they pay on the amount of profits they are willing to share with target company
shareholders, as is done by Garzella and Fiorentino (2014).